How Do You Spell “SUCCESS”?
Three Hallmarks of a Profitable Business

Target Audience: Business Owners, Entrepreneurs, Start-up Companies, Profit Analysis Interest, Financial Managers, Accounting Consulting Firm Advisement Interest, Tax New and Business Updates, Tax Hints and Tips Interest, Companies Who Want to Increase Profits

Every business owner wants his or her company to succeed. Whether you lead a startup or a generations-old enterprise, it’s an easy (and obvious) thing to wish for. But what are the hallmarks of a successful company? Here are three to consider.

1. Strong Revenues

Look at the top of your income statement and you’ll find your revenues — the money generated from your company’s sales of its products and services. This figure needs to be strong if you expect to turn a profit.

 

One way to ascertain how much revenue you need to be profitable is to perform a profitability break-even analysis. It tells you just how much revenue you need to break even and, therefore, provides a baseline for setting your revenue goals. One formula for calculating break-even sales would be:

 

OPERATING EXPENSES + INTEREST EXPENSE
GROSS PROFIT MARGIN

 

So operating expenses of $300,000, interest expense of $20,000 and a gross profit margin of 25% would provide break-even sales of $1.28 million.

 

If you calculate your profitability break-even point and find you may fall short, don’t panic. Examine your sales and see where you can make appropriate changes. Is it time to market more to new prospects or invest more heavily in R&D for new products?

2. Low Production Costs

No matter what business you’re in, you incur costs to produce (and sell) your products or services. The key here is to keep these costs low.

 

Typically, among the biggest production costs is labor. Factoring in benefits and taxes, ask yourself whether the work being performed at your company is increasing the value of your products or services enough to offset the labor costs.

 

In other words, are your employees working efficiently? If not, you might improve efficiency by providing more training, creating better production processes, revamping your organizational framework, investing in more modern facilities or establishing incentive programs.

 

Also look at your materials costs. Technology can assist here: A wide variety of software is now available to help you evaluate materials costs, measure optimal ordering quantities, inventory financial expenses and reduce waste. Just be sure to evaluate any such purchase carefully in light of implementation and training costs.

 

Production overhead is yet another essential cost in this area. These costs differ from operating expenses (see below), which are normally considered to be the costs associated with administrative and sales functions. Many business owners allocate production overhead to volume, but doing so can be suspect. For example, if Product A accounts for 20% of sales volume, you may consider it indispensable. But if it uses 50% of plant space, Product A may not be as profitable as you think.

 

If you find production costs are too high in relation to sales price, you may need to increase the price, find more efficient production methods, or discontinue certain products or services.

3. Minimal Operating Expenses

As you likely know, operating expenses are the costs you incur to keep your company up and running but that aren’t directly attributable to production. These need to be minimal or they could quickly eat into your profit margin.

 

Usually, among the largest operating expenses any business faces is compensation — salaries, wages, commissions, etc. — for management, administrative, sales and marketing personnel. Watch your staffing needs relative to your sales, and make adjustments as appropriate. Also, benchmark your compensation against competitors of similar size to be sure you’re not starting new hires at unreasonably high pay levels or going overboard with bonuses.

 

In addition, look at your marketing costs. You can’t avoid these because, if you don’t publicize your products or services, no one will know to buy them. Nonetheless, review your sales levels relative to marketing costs. Is it time to move in a new direction — more targeted marketing, perhaps?

 

Also, at least twice a year, revisit your R&D budget and review progress made toward established goals. Are you squandering resources on a project that’s unlikely to come to fruition? Remember, there’s a time to aggressively develop and market new products or services and there’s a time to dig in and rely on your strongest sellers.

Forming a Solid Foundation

Granted, there are other elements to your company that contribute to its profitability. But having strong revenues, low production costs and minimal operating expenses will form a solid foundation on which you can build a successful company.

Sidebar: To Assess Profitability, Consider ABC

Many companies assess profitability using traditional cost accounting. Essentially, this approach allocates indirect costs (such as those for facilities, equipment and utilities) to direct costs (such as those for labor and materials).

The problem with traditional cost accounting is that many indirect costs don’t accurately correlate to direct expenses. For instance, the facilities cost allocable to Product B may greatly exceed that for Product A, even though A’s materials and labor are more expensive.

For a more accurate measure of profitability, many business owners are turning to activity-based costing (ABC). It establishes a hierarchy of activities and significant “cost drivers” at a variety of levels.

Some activities (such as packaging materials) are assigned to the individual product level, while others (such as product design) are assigned to the product line level, while transportation costs can be attached to an order. Still others (such as HR tasks) may be assigned to the overall company level.

Using ABC, these specific activities — no matter where they occur in the hierarchy — are linked to a specific product or service and added to the item’s direct labor and material cost. Thus, a clearer profitability picture often comes to light.

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